As a part of the Dodd-Frank Act passed in the late 2000s, the SEC issued amendments to Rule 206(4)- 2, the Custody Rule, under the Investment Advisers Act of 1940. The purpose of the amended rule was to strengthen requirements for the safekeeping of client assets and to prevent the misappropriation or misuse of assets defined as securities or cash.
The Rule requires certain Registered Investment Advisors (RIAs), including those with AUM in excess of $100 million and private fund advisors with AUM in excess of $150 million, to hold client funds and securities with a qualified custodian. These RIAs are subject to annual surprise audits by PCAOB-registered auditors, and if using a related party as their custodian, they must obtain an internal control report from the custodian.
After a few years of moderate enforcement and minimal fines, the SEC now places a major emphasis on compliance with the Custody Rule, with high-profile enforcement actions and large penalties for relatively small violations seemingly the current operation model.
It is important for advisors to understand the Custody Rule. Choice by KT has issued a number of white papers on the topic outlining the Rule and illustrating how advisors can comply.
Since the SEC issued amendments to Rule 206(4)-2, many issuers of private funds have elected to use an independent, qualified custodian in order to meet the requirements of the Rule. Others who are exempt from the Rule often engage a qualified custodian to add a degree of separation and level of transparency for their clients.
By utilizing the service and experience of our firm, private funds and their investors benefit from
- increased transparency and accountability,
- an added degree of separation between an investment advisor and client assets
- saved time and cost associated with the use of a PCAOB-registered firm and preparation of an internal control report, and
- compliance with the Custody Rule and regulatory requirements.